Fueling future growth in Europe

Carlotta De Franceschi
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26 November 2015

How can progressive parties develop a common reform agenda that attracts finances for a sustainable recovery?

“It is not by augmenting the capital of the country, but by rendering a greater part of that capital active and productive than would otherwise be so, that the most judicious operations of banking can increase the industry of the country.”
– Adam Smith

It has been seven years since the Lehman collapse, the event which dragged the world into the worst economic and financial crisis since the Great Depression. Despite small signs of recovery, Europe is akin to a team of clumsy soccer players glimpsing at its nimble global rivals with a mix of worry, envy and puzzlement.

European governments have been talking about spurring growth for quite a while, but have not yet been able to come up with a shared and organic reform agenda for one of the key determinants for growth: finance.

If we think about the broader financial system as a power grid that fuels companies and new ideas, progressives should focus on making the power stations (the banking system, capital markets and alternative finance) more effective as well as improving those frameworks (bankruptcy and tax) that, like switches, enable the grid to become a catalyst for new jobs creation.

As for the banking system, progressives should aim to correct some of the overreach of the recent regulation and of the way Basel III was implemented in Europe, as well as the pursuit of a fast development of securitisation with the joint effort to strengthen domestic public guarantee programs. This will enable banks to effectively serve the real economy as well as fully transfer the benefits of European Central Bank (ECB) policy onto small- and medium-sized enterprises (SMEs).

Progressives should also take the canvas provided by the Capital Markets Union as an opportunity to advocate for a set of policies that makes our capital markets as well as our alternative finance channels more developed and integrated. This will provide our economies with a powerful breath of new oxygen and make our companies more competitive in the global arena.

Following domestic bank rescues in 2008, and faced with angry tax payers, policymakers reacted fast and regulated the banking system by implementing the Basel III framework sooner and more strictly than in the US. As a result, European banks started a massive deleveraging that hurt SMEs as well as families. Even if the original intention was good, the effect of this decision on employment and domestic deficits was not.

The results of the new banking policy were particularly harsh on the European real economy for two reasons: first of all, when compared to US companies that can count on well-developed and deep capital markets, European ones get their financing mostly through the banking sector; second of all, SMEs, which make up about 60 per cent of European GDP and account for about 70 per cent of European employment, struggle to finance through capital markets as opposed to banks. So, mostly by design, while the US in the recovery could leverage two lungs (a developed capital market and a banking sector that could postpone deleveraging – note also that Basel III does not apply to US regional banks), Europe could only rely on a weakened one (a troubled banking sector in deleveraging). In other words, the banking policy that aimed at protecting taxpayers ended up smothering those real economies that, to the same tax payers, provide directly for employment and indirectly for welfare packages.

As for the banking policy, fixing it should be a priority; it takes time for policymakers to develop capital markets and alternative finance channels, and for companies to change funding patterns. Progressives should therefore revise the overreaching points of the regulation and advocate for a shift in perspective from stability to sustainability. At the same time, progressives should put securitisation at the centre of their agenda as a tool to improve the flow of credit and reduce its costs to the real economy and in particular to SMEs. The problem with SMEs is that they are smaller, less transparent, less liquid of an investment and often less creditworthy than larger companies, making them less suited for non-bank financing. If we think of the ECB as a well providing water to European economies and of SMEs as remote villages, securitisation could actually be the powerful network of channels that carry the ECB’s water to the villages. In order to make the network channel really pervasive and watertight, the European commission and domestic governments should work together to enhance the public sector guarantee programs across Europe. While doing so, progressives should ask for a wider availability of European structural funds and more fiscal flexibility to support these programmes. By providing an easier access to the ECB liquidity, public sector guarantee programmes will make our economies immune to future sovereign and capital markets crisis.

As for capital markets and alternative finance, it is a widespread view that if Europe wants to foster growth, it can no longer largely rely on banks to provide for financing and has to further develop and integrate these channels. Strengthening capital markets and alternative finance will also make our corporate sector less dependent on banks and our banking sector more resilient to crisis.

On 30 September 2015, the European commission launched an action plan to execute this vision. As we all know, the devil of this policy will be in the details and while progressives tackle these details, they should not miss the vision for the long term. In particular, progressives should not fear to be ambitious: does the urgency of the matter require a radical approach or, like the one the European commission action plan seems to suggest, an incremental approach?

Especially when facing considerations like supervision (national versus single), which is a key ingredient of an effective and rapid market integration, policy answers are not trivial. As Nicolas Véron points out, the roll out of a single market initiative in unregulated products happens by the elimination of cross-border barriers, while in regulated services, like the financial sector, the enforcement functions (licensing, authorisation and supervision) involve considerable judgment and discretion. Therefore, a key policy decision to achieve rapidly cross-border integration would be to pool these functions at European level and leave a role to the national authorities of local and delegated operations. A less radical step would be to pool these functions at a European level, at least for the alternative finance channels (funds direct lending to SMEs and for peer-to-peer platforms), where the regulation is fairly new and far from being harmonised in its roll-out across Europe.

Furthermore, the reform agenda of progressives cannot overlook the role of pension funds and insurance companies. As a matter of fact, if the ECB is like a well that brings finance to companies through banks, then pension funds and insurers are like wells serving the same function through public as well as private capital markets and infrastructure investments. In particular, progressives cannot deny the priority of reframing the new insurance regulation (Solvency II). The new regime, largely inspired by the prudential one for banks, fails to take into account the long-term nature of insurance investments. By hampering the investment in equities and alternative investment funds, Solvency II eliminates from both public and private capital markets a whole segment of key players that are vital to fuel our economies.

As mentioned earlier, if we think of the financial system, capital markets and alternative finance as power stations in the grid that fuels corporate activity, both bankruptcy and tax regimes are the switches that enable the grid to actually create jobs.

In particular, bankruptcy frameworks affect the ability of a country to foster entrepreneurship, attract investors, sustain employment and provide a positive environment for companies to compete internationally (bankruptcy frameworks affect the overall cost of borrowing, the allocation of capital in the economy and the ability of companies to react and overcome crisis). The European commission is working to harmonise the different frameworks across the EU. From this perspective, progressives should share a common vision of broad pillars to spur entrepreneurship, to create a positive environment for innovative firms and to make companies in general more resilient to crisis. Progressives should therefore pursue a common reform agenda that would make it easier and less penalising for entrepreneurs who fail to try again and start new companies, that support viable companies to restructure their debt and that makes it cheaper and quicker for non-viable companies to finalise a bankruptcy process.

As for the tax regimes, if the objective is to encourage the investment in innovative firms, progressives should propose a reform agenda that is organic and encompasses entrepreneurs, employees, retail investors, institutional investors and corporates. In particular, progressive should advocate for a favourable tax treatment of equity compensation, such as stock options. Such a policy will provide high-growth companies with a valuable currency to attract and retain skilled talent. Progressives should also provide a favourable tax treatment for dividend and capital gains of founders and investors in new innovative companies and seek tax discrimination between long- and short-term investments (as it is in the US). Second, drawing on the European’s best practices, progressives should promote the development of investment products that are suitable to retail investors and liquid for them to invest in innovative SMEs. It is worthwhile supporting these products with tax incentives to allow for the development of markets in the venture capital and dedicated public equity space. Finally, in a context of open innovation, progressives should make the acquisition or investment innovative companies by medium and larger ones tax deductible. This will make it cheaper for our corporates to acquire new technologies and will allow Europe to retain its leading innovative companies.

Some people may wonder whether the progressives’ reform agenda should include some sort of social safety nets for entrepreneurs who bear the risk of starting up a new company. I do not believe social safety nets are a priority for entrepreneurs. What entrepreneurs ask for is the removal of the social stigma associated with failure paired with some sort of comfort that if they fail they will actually be able to start something back again within reasonable time, a positive environment to work and a good upside potential when their company turns into a success. Moving resources away from a favourable treatment of capital gains and dividends could actually drive entrepreneurship into the wrong people and force the ones we really want to migrate to the US or other more competitive landscapes.

Matteo Renzi’s experience proves that sometimes to make a big step forward, countries should completely change direction. Why not be more ambitious then, especially in a field that would allow Europe to unlock its best human capital potential and fuel growth? Why not be brave, and pursue a radical rather than an incremental set of reforms? Progressives should create the conditions for its entrepreneurial class to flourish and create employment, to be rewarded rather than punished when trying something new and to have a pervasive and easy access to finance for the implementation of new ideas. This effort requires a great vision and a gear shift toward the development and integration of finance in Europe. A powerful policy agenda to fuel growth in our economies encompasses banks, insurance companies, pension funds, retail investors, financial products, capital markets infrastructure and supervision, bankruptcy and tax regimes across the EU. In the US people say: ‘If you want to go fast, run alone, but if you want to go far, run together’. Maybe it is time for Europe to wear a common shirt and tackle this match as a real team, not clumsy this time, but on the same level playing field as its global rivals.

Carlotta De Franceschi is founder and president of the Action Institute and former economic adviser to Italian prime minister, Matteo Renzi. She previously spent 12 years in investment banking between New York and London (Credit Suisse, Morgan Stanley and Goldman Sachs) and holds a MBA from Harvard Business School

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The Policy Network Observatory promotes critical debate and reflection on progressive politics. It is centre-left orientated but determinedly challenges social democracy. It is pro-European but restlessly questions EU institutions and practices.